The Key Factor of Great Trading Systems​

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Last week on Trader Tip Tuesday, I talked to you about how marketers deceive traders into looking at systems and getting excited by systems by appealing to win rates and one of the things we said is that a lot of traders have a need to be right bias. They think that if they can find a system, it's never wrong, that is the path to making big money. One of things I showed you last week was the way that marketers deceive you into getting you to think a system is good, to get you to think a system fulfills that need to be right. 

Today, I want to move on, and I want to actually show you how you can actually start to build a great system and we're going to get specifically into the key factor. This is what I showed you last week. I showed you that marketers deceive you by showing you high win rate systems and there was four different ways we talked about them doing it. One is they only show you the closed trades. Every time a trade is or can be a winner, they close it. This builds up a high win rate of closed trades. Meanwhile, there's open trades that are losers. I have a student I'm working with that this is an issue in a system that he's trading. He has win after win after win on trades that are closed, but he has the stocks he's sitting in for a long period of time that are losers. Well they didn't close yet so he didn't sell them, so it's not a loss to sell, but that's bullshit because you definitely can't do that. Having that mentality is really dangerous. 

The second way you do it is you widen or remove the stop, generally you take the stop off, and then you only exit when the trade becomes profitable. This creates trades with horrible reward to risk ratios. Larry Williams was somebody that I learned a tremendous amount about trading from, but Larry would market a lot of systems that would say something like, we're gonna get out on the first profitable close. Or we'll get out on day three, or the first profitable close after day three, which basically implied that he would only get out when the trade became a winner. So they would ride the loser, ride the loser, ride the loser. There's another trader that I studied under who's in the Stock Market Wizards and this trader is known for high win rates. I went out and studied with him and he had a really good advisory service on the stock market, but he would put out his trading signals and his trading signals always had small wins, big risk and he'd have a high win rate. When I followed him, I watched him go six months without a loser, six months without a losing trade, win after win after win after a win, but then bam, bam, bam, three losers in a row. That wiped out half of his account equity, half the money he had made in those six months, just in three losses. The problem when you have a system like this, when you have a bunch of wins and there's these big losses out there lurking, you never feel comfortable spending the money. I mean, how could you, if you spend the money and then the big loss comes, you're totally screwed, your accounts gonna be wiped out. You always have to save the money to be able to fund these big losses when they come. 

Now, another way they do it is use options strategies and they sell options because you can sell options and have a high win rate, a high probability, talk more about this in a minute. Or the fourth was the market the strategy when it's on a long winning streak. So the thing is winning, it's a system that has a high win rate, they know this. They market it as win after win after win and then when it has the big drawdown, kind of like advisor I talked about, well, then they shut it down and they launch a new strategy. So they really do like lying to you. There are high win rate systems and when you see a high win rate system, they usually come from just a handful of variables. One the first is that it's an arbitrage. Arbitrages have incredibly high win rates, 95%, 98%, 99%. Everyone is a winner. Proprietary trading firms are built on arbitrages. They have high win rates, but they typically don't last long because word gets out, there's a lot of really smart traders and if they see an edge that's been done by arbitrage within other trading firms, other traders will come there too, and that arbitrage will go away. Some arbitrages remain, after all these years, what ends up happening is the one who can make money with them is the one with the best technology, or the least competition. Oftentimes, the way they do that is they spend a lot of money on technology. So yes, you win 98% of the time, but you have to spend a lot of money to win. So it's like a loss in another way, you might have to spend 5 million 10 million 50 million $100 million, just to maintain this arbitrage. So if that's the case, you better make a lot of money to pay for those expenses. This is something I dealt with in my proprietary trading firm. 

The second is projected distributions using options and I just mentioned this as ways they deceive you. You can sell options with a projected distribution that leads to high win percentages. If your distributions really wide, if you're inside that distribution, you're gonna make money. Now, those distributions are deceiving, because they're always run at expiration. So many of these distributions between now and expiration, the market can actually go outside the distribution, causing immense pain, causing immense mark to market losses, but then the market comes back inside the distribution and is still as profitable. Again, you get into this situation that, yeah 90% of the time, it makes money, but the 10% of time it goes out of the distribution, you get killed, you get wiped out. Another approach or this is you can use the same approach, but rather than just selling naked options out there, you can sell options spreads. This is a great alternative selling options, because you have a max loss. Now your max loss may still be big, but at least you know what your max loss is, when you sell options, naked, you don't know what your max loss is. It could be massive, it could blow you out, at least when you sell the spreads, you know what your worst case is. 

The fourth is special situations. I used to run an event trading group and our event trading group our win rate was really, really high. Because there would be an event like durable goods tomorrow, and durable goods would come out and there'll be a projection, a forecast of what the durable goods number would be. If it deviated from that forecast at all, we would trade. Well, those trades tend to have really high win rates. There's also special circumstances occasionally around something like an announcement or ruling, some things like this where you can get really high win rates, even some strategies where you can build them, or they have really high wind rates, where you wait for a special circumstance to set up and then you put the trade on. The problem with those is that they don't happen very often. You can't make a living on necessarily just those, but that's the fourth. 

How can we do this? What actually is the key factor? The key factor is large R winning trades, big winning trades are the secret sauce to trading success. Everybody thinks it's win rate, it's not. It's having big winners. One of my favorite traders of all time is Paul Tudor Jones and Paul Tudor Jones talks about that he will not take a trade unless he can make five times what he risks. Five to one means he's risking $1 To make $5. When five to one does for him as allows him to have a hit ratio or win ratio of 20%. That means that he could be right only 20% of the time, and he would still make money if he takes a minimum of five to one. We built this table out, this table is an amazing table, it shows the impact of large R winning trades. If we had a system that if we risked $1 we'd make $1 if we were right, so one to one and we were right 100% of the time, that for every bet that we made, we expect to make $1. That's our expectancy. What's interesting is that if we go for big winning trades and we just use three times, Paul was talking about five times, but if we just use three times, we only have to have a 50% win rate to have an expectancy of $1. The same as perfection at one to one. Small R winning systems have a ceiling in performance, so if you have a system with a high win rate, but the wins are small, there's a ceiling on how much you can actually make. Large R winning trades and systems have large R winners have no limit.

I'll say this again, they have no limit. These large R winners have massive implications for your trading if you can embrace the concept. You can see we mentioned Paul, so with Paul if he can have a win rate of 50% and he only does five to one trades,  his expectancy is $2, which is insane. If you have any kind of frequency with $2 You'd be rich beyond what you can imagine and that's what Paul is. You can see that out here, it just gets way, way, way above one. If large R winning trades have the secret sauce, what is the secret recipe? What is the right recipe? In this it's that we go for big R winning trades and we get our win percentage up. Well, it seems obvious, but this is why I want you to understand, if you just go for big R winning trades and your win rate is too low, you can never scale it because you'll always scale into a drawdown. This is where Dr. Thorpe came up with the concept of Sqn, the system quality number. System quality number really blends win rate with large R winners. If you can just have a minimum of three to one, and preferably five to one or greater for your potential R winner and then you can blend that with a win rate that has to be greater than 40% and preferably greater than 50%. Notice it doesn't have to be 70% or 80% or 90% or 98%, you can just get it over 50 and you have the potential for big wins in every trade, that alone will make you a lot of money. 

I have to say this again and again. Getting your R multiple, getting your potential R at a good level is probably the single greatest thing you can do to improve your performance. I see this in options trades all the time. I see people that you know they'll selves they'll sell options are they'll sell spreads and their mind is wow, it's gonna go to zero, so I'll just do that, but if the reward to risk is poor, it's really hard to overcome. You have to be right all the time, but if you just say I'm only going to trade, I'm only going to trade when my reward to risk is a certain level three to one or greater, let's just say, that it's going to cover all your mistakes. It's going to make life so much easier. It's going to make sure that you allocate your focus, not just your capital, but your mental focus your mental capital, that you're going to allocate it to the best opportunities and you'll benefit from those and because of that you'll trade them better. This is something we talk about all the time in our ecosystem with our students, the importance of large R winning trades. If you embrace this have changed your life. I'll see you next Tuesday when I show you different ways just like today to think about how to take your trading to an elite level. I'll see you next week.